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1/ Margin Trading 101 If you follow the stock market and financial news, you’ve undoubtedly heard a lot of talk about margin trading or margin calls. But what is margin trading and how does it work? Here’s Margin Trading 101!
2/ First, some definitions. “Buying on margin” is just the financial jargon for using loaned money to buy assets. Someone loans you money and you use it to buy a stock - you are buying on margin. “Margin” is defined as the total value of the asset minus the borrowed amount.
3/ When you buy on margin in a brokerage account, the stocks you buy are collateral. This is the same as buying a house with a mortgage. The house is collateral for the loan. So how does it work and what is the deal with the dreaded margin call? Let’s look at a simple example.
4/ Imagine you want to buy a plot of beachfront land on the coast of Nicaragua. It’s beautiful, but still pretty cheap due to political instability. It’s the next Costa Rica! You’re sure of it. The land costs $1M today. So you ask your rich friend Jimmy for a loan to buy it.
5/ You put up $200K and Jimmy loans you the remaining $800K. You buy the land and are the proud owner of prime Nicaraguan real estate. Congratulations, you just bought on margin! Margin = Asset Value - Loan Value Margin = $1M - $800K Margin = $200K
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6/ Shortly after you buy the land, riots break out across the country, causing tourism to grind to a halt. Land values plummet. Jimmy starts to get nervous. He previously had $1M of collateral covering his $800K loan, but now the market value of the collateral is just $500K!
7/ Jimmy calls you, explaining that he needs you to put up some additional cash as collateral to make him whole. Otherwise, he will be forced to seize the collateral (your Nicaraguan beachfront land!) and walk away. This was a “margin call” (literally and figuratively!).
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8/ In an alternate universe, if the land value had increased, the returns on your $200K investment would have been amplified given you bought the land on margin. Effectively, buying on margin is a way to amplify returns on the upside, but it also amplifies risks on the downside!
9/ It is essential to educate yourself before entering into a loan agreement (whether for a house or a brokerage account). Never trade on margin if you are going to be in financial distress if you get margin called! So that’s a simple primer on the topic. I hope it was helpful!
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